The Key to Investing Success: Risk Mitigation
I ride my bike three miles to work every day in New York City. I would imagine some of you have already written me off as crazy, but let’s table my psych eval right now to talk about risk. Every day on my commute I take a risk, but I participate in the city I love, feel the changes in the seasons, and get exercise. I try to decrease the probability of an accident by following the rules of the road and having lights and reflectors on my bike. I try to limit the impact of a potential accident by not riding too fast and wearing a helmet.
For every action there is risk, and we must measure both the probability of the risk playing out and the severity of the impact. I will probably have a pleasant bike ride home tonight, but there is also a range of negative impacts should I crash. Risk is sometimes the highest when we feel the most comfortable. I may look up to enjoy the skyline and not notice the pothole about to swallow me whole. The same is true in investing. There are risks in all investments, probabilities about their occurrence, amounts of potential pain, and unfortunately no reliable way to know when they will occur.
Currently, stock valuations are through the roof driven by the TINA (There Is No Alternative) equity market where other asset classes seem hardly worth the effort. Masses of young people with the excitement of easy trading (and profits) at their fingertips have recently driven up the number of equity investors from a 2012 low, while the proliferation of cheap index products has pushed stock prices to record highs. The Fed has been teaching us since the Great Recession that they will do what it takes to prop up the stock market, through low rates, bailouts, and direct payments.
The risk of a market crash right now feels slim as we cruise into the third quarter with year-to-date S&P 500 returns almost doubling an average year at the time of writing, after the two previous years far exceeded expectations. That may be the thing to watch out for. We know a hot streak can continue much longer than seems rational, but how will we know when it is time to bounce from our almost free index funds into the safety of… all those other things that hardly seem worth it.
Every drop since 2009 has been a great buying opportunity, but we never know that until after the fact. Many investors in the market today have not known what it feels like to see one’s portfolio value grind lower month after month, or year after year, inducing panic sales near the bottom of a protracted decline.
The current reinforcement that “everything will always be better in my portfolio if I just suffer for a little while” is not born out by history. Tech stocks took 17 years to recover after the dot-com bust. We have had on average two roughly 36% declines per decade. Inflation has devastated those on fixed incomes. These things happen, they just have not happened recently, so we tend to feel like they will not. The skyline looks great, doesn’t it…
Managing the risk in a portfolio is the priority: If you lose your assets, you can’t grow them. One needs to proactively plan for challenging markets. Incorporating bonds into a portfolio to adjust volatility is a classic way to do this, but the dual risks of inflation and rising interest rates to conventional bonds do not make them very appealing right now. Nor do negative real yields. Using nimble fixed-income strategies and hedged or tactical equities as a portion of one’s allocation may help plan for the blow of cratering markets without selling out of stocks.
Rather than suggest specific equity and fixed-income strategies that I think will perform reasonably well on the upside and protect on the downside I would like to set forth some criteria to help one draw their own conclusions. For fixed income, I believe asking the following questions will help guide one in their decision-making.
- Is the yield greater than that of investment-grade bonds?
- Does it have a proven track record of limiting losses in fixed income declines?
- Is it agile enough to accommodate for both inflation and rising interest rates?
- Has it been uncorrelated to equities in bear markets?
By answering these questions, one may see that the conventional bonds that have become so entrenched as the “safe part of the portfolio” may be an additional risk.
For equities I believe looking for strategies that provide full exposure to markets or indexes with an upmarket correlation of greater than 50% and low, but likely not negative, down-market correlation.
- Does the strategy have the ability to disconnect from falling markets or exit fully out of equities?
- Is it market correlated?
- Is the upside capped?
- Is there a floor or can it break through it?
- How has it performed in previous bull-to-bear transitions?
I do not like stopping at traffic lights, or going the right way down one-way streets, and wearing a helmet is uncomfortable, but I do these things because I am most in danger when I am not focused on where I might get creamed.
Hedging your portfolio against the ever-present risk could cost you bragging rights at the cocktail party about how high your portfolio has stretched this year, but think of what it could cost you on the other side. No one wants to work longer, scale back, or start over again, but these risks are real and we all know more than one person who has ridden too close to the sun.
The key is to make sure the risk mitigation is in place when it feels wrong. If it feels right, it is likely too late. Keep your eyes on the road.
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This commentary is intended to provide general information only and should not be construed as an offer of specifically-tailored individualized advice, and no representation is being made as to whether the information provided herein would be beneficial for any or for a specific Employer Benefit Plan or investor.
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